I have long stated that targets of “financial stability” and “price stability” (monetary policy) were important – but should be performed in separate, yet independent, operational terms (here and here). Namely, keep the central bank focused on monetary policy while another organisation/operational entity solely focuses on the more long term goal of financial stability.

In my view separation is important for communication – by separating the two people can tell when actions are framed towards certain goals. By having one organisation/entity trying to attempt both, you risk muddying the waters – which in turn will lead to worse outcomes.

Interestingly, empirics tells us that bank risk not only responds to a rate cut, but that it also matters how long rates are kept low (Maddaloni and Peydro forthcoming, Altunbas et al. 2010). This relates to the argument that in the years leading up to the crisis rates were kept low for too long. Our model can provide some reasoning for why this can be damaging. We make the model dynamic and add a crucial feature, maturity mismatch.

In contrast to their short-term liabilities, banks’ assets are long-term. Because of this, banks will only adjust their portfolios if they foresee that a change to their environment is of long duration. A short-rate cut will not push them to take more risk. But a long lasting cut will. A monetary authority that considers financial imbalances therefore has a different timing of policy than an authority that cares only about inflation and output gap stabilisation.

This argument is compelling, and if you have a central bank with only one tool (the cash rate) I think I would be convinced.

However, if central banks are also willing to put in place measures to try and reduce maturity mismatch, and adjust the cyclical nature of banks reserves – then I believe we have multiple instruments. In this case, the use of each individual instrument should still be directed at a specific target – to make communication clear.

Yes, these instruments are related, and the choice of a financial stability institution will influence the choice of a monetary institution. But this is already the case with fiscal and monetary policy – and yet we believe we can keep monetary policy independent.

The fact is that the balancing of expectations, and the ability to communicate policy to manage these expectations, is the key part of monetary – and even financial stability – policy. As this is the case, I continue to find it important to keep these two policy targets operationally separate.

This is an issue I find fascinating, and I’m looking forward to seeing how things develop over the next decade – and why.

The problem, I think, with the Vox piece is that it treats maturity mismatch and duration (interest rate) mismatch as one and the same. That may have been true in the past, but modern derivatives markets allows banks to separate them out and hedge away the latter. In fact, any bank that didn’t manage its interest rate exposure this way would probably be ostracised by lenders. There’s no regulatory response needed here – the market has dealt with it.

Maturity mismatch – the risk of not being able to roll over debt as it matures – can’t be hedged. There is a case for regulation here, but it’s a question of quantitative targets – such as the core funding ratio that the RBNZ already imposes – rather than a price-based tool like the cash rate.

As I said in the previous posts (I still agree with what I wrote in 2009 – phew!), if communication is the deciding factor then I’d favour integration. Any conflicts of interest between inflation targeting and financial stability are best worked through internally before subjecting them on the public. Though of course having a single entity doesn’t guarantee that will be the case, as we’ve seen with the RBNZ.

Having read Alan Bollard’s take on the “crisis” i am evermore convinced we should have an overall goal of financial stability with monetary policy as a part of that, and not separate.

Sadly there won’t be any move in this direction with National but I’m pleased to see all other parties looking at changes to the RB Act and presumably the Public Finance Act as well. Or I guess we can keep repeating the dose 🙂

Miguel Sanchez

But Labour & co are agitating for a policy of lower and less volatile interest rates, which is precisely the opposite of what that article recommends:

“Financial stability objectives are then shown to make a monetary authority more conservative and more aggressive. Conservative as it sets higher rates on average. And aggressive because, in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. Keeping cuts short is crucial as bank risk responds primarily to stable low rates. Within the short span, cuts then must be deep to achieve standard objectives.”

Good points. I agree with you, and the fact that targeting maturity mismatch requires a different tool is appropriate.

But, in the case of communication I still believe that the existence of two tools and two targets requires operational separation. The degree of communication between monetary and financial stability authorities prior to a decision is an issue that should be looked at – but it is no different than the idea of communication between monetary and fiscal authorities.

I believe that the decisions regarding monetary and financial stability issues should be kept separate, but there should be discussion between the groups – but mainly because I think the same should be true between the RBNZ and Treasury. If fiscal policy is going to be set some way, the RBNZ should be able to tell government “hey, that will push us to do this with interest rates to meet our mandate of stable price growth”.

In this sense, we still have operational separation between the groups – but the goals for policy are well set out and co-ordinated, so that policy doesn’t fluctuate randomly but the separate goals are communicated in such a way that individuals can form appropriate expectations.